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3

CHAPTER

Part 1 Value

Valuing Bonds

I

nvestment in new plant and equipment requires money—

often a lot of money. Sometimes firms can retain and

accumulate earnings to cover the cost of investment, but

often they need to raise extra cash from investors. If they

choose not to sell additional shares of stock, the cash has

to come from borrowing. If cash is needed for only a short

while, firms may borrow from a bank. If they need cash for

long-term investments, they generally issue bonds, which are

simply long-term loans.

Companies are not the only bond issuers. Munici-

palities also raise money by selling bonds. So do national

governments.

We start our analysis of the bond market by looking at the

valuation of government bonds and at the interest rate that

the government pays when it borrows. Do not confuse this

interest rate with the cost of capital for a corporation. The

projects that companies undertake are almost invariably risky

and investors demand higher prospective returns from these

projects than from safe government bonds. (In Chapter 7 we

start to look at the additional returns that investors demand

from risky assets.)

The markets for government bonds are huge. In Novem-

ber 2014, investors held $12.9 trillion of U.S. government

securities, and U.S. government agencies held a further

$5.1 trillion. The bond markets are also sophisticated. Bond

traders make massive trades motivated by tiny price discrep-

ancies. This book is not for professional bond traders, but if

you are to be involved in managing the company’s debt, you

will have to get beyond the simple mechanics of bond valua-

tion. Qualified financial managers understand the bond pages

in the financial press and know what bond dealers mean

when they quote spot rates or yields to maturity. They realize

why short-term rates are usually lower (but sometimes higher)

than long-term rates and why the longest-term bond prices

are most sensitive to fluctuations in interest rates. They can

distinguish real (inflation-adjusted) interest rates and nominal

(money) rates and anticipate how future inflation can affect

interest rates. We cover all these topics in this chapter.

Companies can’t borrow at the same low interest rates as

governments. The interest rates on government bonds are

benchmarks for all interest rates, however. When government

interest rates go up or down, corporate rates follow more or

less proportionally. Therefore, financial managers had better

understand how the government rates are determined and

what happens when they change.

Corporate bonds are more complex securities than

government bonds. It is more likely that a corporation may

be unable to come up with the money to pay its debts, so

investors have to worry about default risk. Corporate bonds

are also less liquid than government bonds: they are not as

easy to buy or sell, particularly in large quantities or on short

notice. These complications affect the “spread” of corporate

bond rates over interest rates on government bonds of similar

maturities.

This chapter only introduces corporate debt. We take a

more detailed look in Chapters 23 and 24.